Insider trading

Insider trading is the trading of a corporation's stock or other securities (e.g. bonds or stock options) by individuals with potential access to non-public information about the company. In most countries, trading by corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information. However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company.

In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the U.S., defined as beneficial owners of ten percent or more of the firm's equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation (broadly speaking) and that their trades otherwise convey important information (e.g., about the pending retirement of an important officer selling shares, greater commitment to the corporation by officers purchasing shares, etc.)

Illegal insider trading is believed to raise the cost of capital for securities issuers, thus decreasing overall economic growth.

However, it is relatively easy for insiders to capture insider-trading like gains through the use of transactions known as "open market repurchases." Such transactions are legal and generally encouraged by regulators through safeharbours against insider trading liability.

Legal insider trading

Legal trades by insiders are common, as employees of publicly traded corporations often have stock or stock options. These trades are made public in the United States through Securities and Exchange Commission filings, mainly Form 4. Prior to 2001, U.S. law restricted trading such that insiders mainly traded during windows when their inside information was public, such as soon after earnings releases. SEC Rule 10b5-1 clarified that the prohibition against insider trading does not require proof that an insider actually used material nonpublic information when conducting a trade; possession of such information alone is sufficient to violate the provision, and the SEC would infer that an insider in possession of material nonpublic information used this information when conducting a trade. However, SEC Rule 10b5-1 also created for insiders an affirmative defense if the insider can demonstrate that the trades conducted on behalf of the insider were conducted as part of a pre-existing contract or written binding plan for trading in the future. For example, if an insider expects to retire after a specific period of time and, as part of his or her retirement planning, the insider has adopted a written binding plan to sell a specific amount of the company's stock every month for two years and later comes into possession of material nonpublic information about the company, trades based on the original plan might not constitute prohibited insider trading.

Illegal insider trading

Rules against insider trading on material non-public information exist in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably. Sections 16(b) and 10(b) of the Securities Exchange Act of 1934 directly and indirectly address insider trading. Congress enacted this act after the stock market crash of 1929. The United States is generally viewed as having the strictest laws against illegal insider trading, and makes the most serious efforts to enforce them.

Definition of "insider"

In the United States and Germany, for mandatory reporting purposes, corporate insiders are defined as a company's officers, directors and any beneficial owners of more than ten percent of a class of the company's equity securities. Trades made by these types of insiders in the company's own stock, based on material non-public information, are considered to be fraudulent since the insiders are violating the fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has undertaken a legal obligation to the shareholders to put the shareholders' interests before their own, in matters related to the corporation. When the insider buys or sells based upon company owned information, he is violating his obligation to the shareholders.

For example, illegal insider trading would occur if the chief executive officer of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing that the share price would likely rise.

In the United States and many other jurisdictions, however, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned, but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be imputed; for example, in many jurisdictions, in cases of where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he or she trades on the basis of this information.

Liability for insider trading

Liability for inside trading violations cannot be avoided by passing on the information in an "I scratch your back, you scratch mine" or quid pro quo arrangement, as long as the person receiving the information knew or should have known that the information was company property. It should be noted that when allegations of a potential inside deal occur, all parties that may have been involved are at risk of being found guilty.

For example, if Company A's CEO did not trade on the undisclosed takeover news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred.

Misappropriation theory

A newer view of insider trading, the "misappropriation theory," is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer's stock) is guilty of insider trading.

For example, if a journalist who worked for Company B learned about the takeover of Company A while performing his work duties, and bought stock in Company A, illegal insider trading might still have occurred. Even though the journalist did not violate a fiduciary duty to Company A's shareholders, he might have violated a fiduciary duty to Company B's shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering).

Proof of responsibility

Proving that someone has been responsible for a trade can be difficult, because traders may try to hide behind nominees, offshore companies, and other proxies. Nevertheless, the U.S. Securities and Exchange Commission prosecutes over 50 cases each year, with many being settled administratively out of court. In order for a case against insider trading to stand up in court, it must not only infer the trading of information but also have the plus factor. The plus factor is one approach to prove responsibility and is the additional facts implying guilt or deception and to detect this, the government put into consideration six key pieces of evidence: parties access to the information, their relationship to one another, the timing of the contract involved, the timing of their trades, trade patterns, and any attempt to hide their relationship. The SEC and several stock exchanges actively monitor trading, looking for suspicious activity.

Trading on information in general

Not all trading on information is illegal insider trading, however. For example: if, while dining at a restaurant, you hear the CEO of Company A at the next table telling the CFO that the company's profits will be higher than expected, and then you buy the stock, you are not guilty of insider trading unless there was some closer connection between you, the company, or the company officers. However, information about a tender offer (usually regarding a merger or acquisition) is held to a higher standard. If this type of information is obtained (directly or indirectly) and there is reason to believe it is non-public, there is a duty to disclose it or abstain from trading.

Tracking insider trades

Since insiders are required to report their trades, others often track these traders, and there is a school of investing which follows the lead of insiders. This is of course subject to the risk that an insider is making a buy specifically to increase investor confidence, or making a sell for reasons unrelated to the health of the company (e.g. a desire to diversify or pay a personal expense).

Insider trading vs. insider information

In the industry of investing, there is a difference between insider trading and insider information. For example, there was information released about Continental and United Airlines merging in late 2009. At the turn of the year, it was believed that the merger was going to fall through and that the two companies were not going to act upon the merger. By summer of 2010 and the final signing of the legal details (a), the deal went through officially. The acquisition of the added resources, capital, and infrastructure for the two companies would easily drive up the stock price of the new “company” under UAL on the New York Stock Exchange. With this done, insider traders could have acted back when there were rumors assuming the price would have gone up. However, insider informants “said” that the merger fell through and nothing was going to happen. This creates gossip in the trading world and information that an insider can be giving out to friends and family may not be completely accurate since they do not know the full story.

Generally, insider traders act upon information that they believe to be true that is not available to the public giving them the upper hand in making profits. Insider informants pass along information in the form of gossip and do not personally buy or sell stock based on projections. Whether or not either party is acting illegally is solely in the hands of the SEC.

American insider trading law

The United States has been the leading country in prohibiting insider trading made on the basis of material non-public information. Thomas Newkirk and Melissa Robertson of the U.S. Securities and Exchange Commission (SEC) summarize the development of U.S. insider trading laws. Insider trading has a base offense level of 8, which puts it in Zone A under the U.S. Sentencing Guidelines. This means that first-time offenders are eligible to receive probation rather than incarceration.

Members of the U.S. Congress are not exempt from the laws that ban insider trading, however, they generally do not have a confidential or fiduciary relationship with the source of the information they receive and accordingly, do not meet the definition of an "insider".

Common law

U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before the Securities Exchange Act was passed, the United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew it was about to jump up in price committed fraud by buying while not disclosing his inside information.

Section 15 of the Securities Act of 1933 contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934.

Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits fraud related to securities trading.

The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading.

SEC regulations

SEC regulation FD ("Fair Disclosure") requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure "promptly."

Insider trading, or similar practices, are also regulated by the SEC under its rules on takeovers and tender offers under the Williams Act.

Court decisions

Much of the development of insider trading law has resulted from court decisions.

In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading.

In 1909, the Supreme Court of the United States ruled in Strong v. Repide that a director upon whose action the value of the shares depends cannot avail of his knowledge of what his own action will be to acquire shares from those whom he intentionally keeps in ignorance of his expected action and the resulting value of the shares. Even though in general, ordinary relations between directors and shareholders in a business corporation are not of such a fiduciary nature as to make it the duty of a director to disclose to a shareholder the general knowledge which he may possess regarding the value of the shares of the company before he purchases any from a shareholder, yet there are cases where, by reason of the special facts, such duty exists.

In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)

The Dirks case also defined the concept of "constructive insiders," who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.

In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of "Heard on the Street" columns appearing in the Journal.

The court ruled in Carpenter: "It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principal for any profits derived therefrom."

However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan, 521 U.S. 642, 655 (1997). O'Hagan was a partner in a law firm representing Grand Metropolitan, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options.

The Court rejected O'Hagan's arguments and upheld his conviction.

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

The Court specifically recognized that a corporation’s information is its property: "A company's confidential information...qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another."

In 2000, the SEC enacted Rule 10b5-1, which defined trading "on the basis of" inside information as any time a person trades while aware of material nonpublic information– so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades.

Insider trading by members of Congress

Members of Congress are exempted from insider trading laws and thus can act on information they are bound to gain in the course of their congressional activities, although house rules may consider it unethical. A 2004 study found that stock sales and purchases by Senators outperformed the market by 12.3% per year. Peter Schweizer points out several examples of insider trading by members of Congress, including action taken by Spencer Bachus following a private, behind-the-doors meeting on the evening of September 18, 2008 when Hank Paulson and Ben Bernanke informed members of Congress about the imminent financial crisis, Bachus then shorted stocks the next morning and cashed in his profits within a week. Also attending the same meeting were Senator Dick Durbin and John Boehner; the same day (trade effective the next day), Durbin sold mutual-fund shares worth $42,696, and reinvested it all with Warren Buffett. Also the same day (trade effective the next day), Congressman Boehner cashed out of an equity mutual fund.

Security analysis and insider trading

Security analysts gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus their activities may easily cross legal lines if they are not especially careful. The CFA Institute in its code of ethics states that analysts should make every effort to make all reports available to all the broker's clients on a timely basis. Analysts should never report material nonpublic information, except in an effort to make that information available to the general public. Nevertheless, analysts' reports may contain a variety of information that is "pieced together" without violating insider trading laws, under the mosaic theory. This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented.

In May 2007, a bill entitled the "Stop Trading on Congressional Knowledge Act, or STOCK Act" was introduced that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs and also regulate analysts or "Political Intelligence" firms that research government activities. The bill has not passed.

Arguments for legalizing insider trading

Some economists and legal scholars (e.g. Henry Manne, Milton Friedman, Thomas Sowell, Daniel Fischel, Frank H. Easterbrook) argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material nonpublic information benefits investors, in general, by more quickly introducing new information into the market.

Milton Friedman, laureate of the Nobel Memorial Prize in Economics, said: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.

Other critics argue that insider trading is a victimless act: A willing buyer and a willing seller agree to trade property which the seller rightfully owns, with no prior contract (according to this view) having been made between the parties to refrain from trading if there is asymmetric information. The Atlantic has described the process as "arguably the closest thing that modern finance has to a victimless crime".

Legalization advocates also question why "trading" where one party has more information than the other is legal in other markets, such as real estate, but not in the stock market. For example, if a geologist knows there is a high likelihood of the discovery of petroleum under Farmer Smith's land, he may be entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith of the geological data. Nevertheless, circumstances can occur when the geologist would be committing fraud if, because he owes a duty to the farmer, he did not disclose the information; e.g., if he had been hired by Farmer Smith to assess the geology of the farm.

Advocates of legalization make free speech arguments. Punishment for communicating about a development pertinent to the next day's stock price might seem to be an act of censorship. If the information being conveyed is proprietary information and the corporate insider has contracted to not expose it, he has no more right to communicate it than he would to tell others about the company's confidential new product designs, formulas, or bank account passwords.

There are very limited laws against "insider trading" in the commodities markets, if, for no other reason, than that the concept of an "insider" is not immediately analogous to commodities themselves (e.g., corn, wheat, steel, etc.). However, analogous activities such as front running are illegal under U.S. commodity and futures trading laws. For example, a commodity broker can be charged with fraud if he or she receives a large purchase order from a client (one likely to affect the price of that commodity) and then purchases that commodity before executing the client's order in order to benefit from the anticipated price increase.

Legal differences among jurisdictions

The US and the UK vary in the way the law is interpreted and applied with regard to insider trading.

In the UK, the relevant laws are the Criminal Justice Act 1993 Part V Schedule 1 and the Financial Services and Markets Act 2000, which defines an offence of Market Abuse. It is also illegal to fail to trade based on inside information (whereas without the inside information the trade would have taken place). The principle is that it is illegal to trade on the basis of market-sensitive information that is not generally known. No relationship to the issuer of the security is required; all that is required is that the guilty party traded (or caused trading) whilst having inside information.

Japan enacted its first law against insider trading in 1988. Roderick Seeman says: "Even today many Japanese do not understand why this is illegal. Indeed, previously it was regarded as common sense to make a profit from your knowledge."

In accordance with EU Directives, Malta enacted the Financial Markets Abuse Act in 2002, which effectively replaced the Insider Dealing and Market Abuse Act of 1994.

The "Objectives and Principles of Securities Regulation" published by the International Organization of Securities Commissions (IOSCO) in 1998 and updated in 2003 states that the three objectives of good securities market regulation are (1) investor protection, (2) ensuring that markets are fair, efficient and transparent, and (3) reducing systemic risk. The discussion of these "Core Principles" state that "investor protection" in this context means "Investors should be protected from misleading, manipulative or fraudulent practices, including insider trading, front running or trading ahead of customers and the misuse of client assets." More than 85 percent of the world's securities and commodities market regulators are members of IOSCO and have signed on to these Core Principles.

The World Bank and International Monetary Fund now use the IOSCO Core Principles in reviewing the financial health of different country's regulatory systems as part of these organization's financial sector assessment program, so laws against insider trading based on non-public information are now expected by the international community. Enforcement of insider trading laws varies widely from country to country, but the vast majority of jurisdictions now outlaw the practice, at least in principle.

Larry Harris claims that differences in the effectiveness with which countries restrict insider trading help to explain the differences in executive compensation among those countries. The U.S., for example, has much higher CEO salaries than do Japan or Germany, where insider trading is less effectively restrained.

By nation

Norway

In 2009, a journalist in Nettavisen (Thomas Gulbrandsen) was sentenced to 4 months in prison for insider trading.

The longest prison sentence in a Norwegian trial where the main charge was insider trading, was for 8 years (where 2 of the years are suspended) when Alain Angelil was convicted in a district court on December 9, 2011.

See also

• Abuse of information
• Efficient market hypothesis
• ImClone stock trading case
• Eugene Plotkin
• Private Securities Litigation Reform Act
• Raj Rajaratnam
• Rene Rivkin
• Securities fraud
• Securities Regulation in the United States

References

• Stephen M. Bainbridge, Securities Law: Insider Trading (1999) ISBN 1-56662-737-0.
• Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" ISBN 0-19-514470-8.
• Grechenig, The Marginal Incentive of Insider Trading: an Economics Reinterpretation of the Case Law, 37 The University of Memphis Law Review 75-148 (2006).
• Review of Financial Studies; May2009, Vol. 22 Issue 5, p1845-1887, 43p
• Grechenig, Positive and Negative Information - Insider Trading Rethought,

External links

General information

• Insider Trading Informational page from the U.S. Security and Exchange Commission (SEC)
• Testimony Concerning Insider Trading, by Linda Thomsen, Director of the SEC's Division of Enforcement, before the U.S. Senate Judicial Committee (September 26, 2006)
• SEC Forms 3, 4 and 5
• Insider Trading: Information on Bounties

Articles and opinions

• Timothy Sullivan We're still against fraud, aren't we? United States v. O'Hagan: Trimming the Oak in the wrong season St. John's Law Review, Winter 1997.
• An opinion on Why Insider Trading Should be Legal Larry Elder Interviews Henry Manne
• Why forbid insider trading? by Ajay Shah, consultant to the Ministry of Finance, India
• Information, Privilege, Opportunity and Insider Trading by Robert W. Mcgee and Walter E. Block– a scholarly work that opposes regulations against insider trading
• Free Samuel Waksal argues that businessman's insider trading should not be considered a crime
• Rule: Ownership Reports and Trading by Officers, Directors and Principal Security

Data on insider trading

• SEC Edgar Database on current Form 3, Form 4 and Form 5 filings